What are the steps to use financial analysis for evaluating business profitability? (2024)

In order to get a complete history of financial statements, it’s best to look at the previous 5 years of P&L, BS and Cashflows. This will give us the general trend of profits, assets, liabilities and cash movements.We can then look at various ratios to determine how the next few years will pan out and what we can do to improve all metrics for the business. It’s also vital to look at the SOCE so we can see what changes have occurred in the capital of the company and if any extra money has been raised.

To evaluate business profitability using financial analysis, gather financial statements, calculate key ratios, analyze trends, compare to industry benchmarks, assess liquidity and debt levels, examine cash flow, evaluate ROI, consider non-financial factors, identify strengths and weaknesses, and use the analysis to make informed decisions, while seeking expert advice when needed.

For the C-suite, understanding these ratios is vital for strategic decision-making. For instance, a declining return on assets could indicate that it may not be the best time to invest in new capital-intensive projects. Additionally, monitoring liquidity ratios like the current ratio can provide insights into whether the company has enough resources to meet short-term obligations. These are critical data points for CFOs when considering debt financing or issuing new shares.

Financial ratios can be divided into 4 categories:-1) Liquidity ratio: This measures a company’s ability to pay short-term debts.2) Leverage ratio: Measures company’s debt levels and how they compare to its assets and equity.3) Activity ratio: Measures how efficiently a company is using its resources.4) Profitability ratio: Measures a company’s ability to generate profits.

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Financial ratios play a crucial role in assessing business profitability. Profit margin ratios, like gross, operating, and net profit margins, reveal how efficiently a company converts revenue into profit. Return ratios, such as return on assets, equity, and invested capital, measure the effectiveness of capital utilization. Efficiency ratios, like asset, inventory, and receivables turnovers, indicate how well resources are employed to generate revenue and profit. These metrics collectively provide a comprehensive picture of a business's financial health and performance.

Size of the the company/organization also matters for the benchmarking period. When you evaluate the data collected, usually average ratios of the industry are taken into account and as the big companies' numbers are intense in total industry, small or medium sized companies' data may seem inaccurate.

Companies within the same sector but at different stages of growth will have different benchmarks. However as an average company, one should always see where one sits within the range of all companies when it comes to these metrics, and see how they can improve by emulating their competitors.Benchmarking is a great way not only to improve your own performance, but the sector as a whole as it could mean more growth for the whole sector and higher business valuations.

In the M&A cycle as part of the due diligence, all these ratios and charts are populated in a data book and each line on the P&L, BS and Cashflow is analysed. Anomalies can be stripped out and earnings can be normalised as a benchmark of performance in any given year.Only by doing these charts and storytelling can we fix any issues and double down on the good things the business may be doing.

For CXOs, integrating predictive analytics with these analysis methods could be a game-changer. For example, applying machine learning models to past financial ratios could potentially forecast future performance, allowing for proactive decision-making. Data-driven approaches can also identify hidden correlations between different financial ratios and external market indicators.Horizontal analysis might not account for seasonality effects, and vertical analysis often ignores the context of market conditions.

Thinking about context is so important when interpreting and communicating results from financial analyses. Without an understanding and consideration of the context, the results of your financial analysis can contribute to wrong decisions

This part is the most crucial as all parties need to be involved and on the same page, singing from the same hymn.This is where powerful visual tools can explain things in a simple manner so all non-finance people can understand.Tableau, PowerBi, Excel and PowerPoint should be used for maximum impact.

Objective of financial analysis is to achieve Operational Excellence. Simple meaning of Op Excellence is to make the most of your available resources. Capturing business processes leads to Digitization. Digitization leads to Quality Data. Quality Data leads to Analysis. Analysis leads to Decision Making. Decision Making leads to Operational Excellence.

When doing your analysis you will bump into certain values that hold “the key”Identifying them comes with experience, but dont be afraid to go deep into the accounting and ask questions. Almost anybody can do the analysis, but if you know where it is coming from and take your time to understand the why, it is the difference. This is specially so if you are a consultant.